Friday, April 07, 2006

Problematic Cash Flow From Renting Out Houses

A couple we'll call Alf and Doris live in a B.C. city. Alf, 60, is retired but active in community affairs. Doris, 56, is a corporate administrator. She plans to retire within a few months.

With a gross annual income of $137,000 and a problematic cash flow from renting out houses, they hope to enjoy a retirement that has taken years to build. Yet the nagging question is whether their current $2,250,000 in net assets will be enough. "Can we support our lifestyle when we fully retire with the assets we have today?" Alf asks.

Alf, who has no company or government pension other than the $523 he draws from the Canada Pension Plan each month, is heavily dependent on his investments, 95 per cent of which are in residential property including their own home.

Doris, whose annual earnings of $117,000 make up the largest part of family income, plans to retire before the end of 2006. The couple will soon have to face a dramatic reduction in income, for Doris's current income of almost $10,000 a month will drop to a pension, albeit indexed, that will pay $3,386 each month in nine years when she reaches 65. Alf is five years away from being able to draw Old Age Security, currently $484.63 a month. Doris has four years to go from the earliest date she can receive Canada Pension Plan payments and nine years from the time she can expect OAS.

Alf collects rental income from five houses on which there are accrued capital gains of $1,175,000. He built his real estate slowly, buying houses when the market dipped, building one house himself, and doing maintenance and improvements on the properties. He has used income from the houses to develop a portfolio of stocks worth $120,000 that is invested in large-capitalization Canadian equities. He realizes that his concentration on residential property has produced large capital gains on paper, but his properties carry a good deal of risk.

What our expert says

Facelift asked Doug Macdonald, a Registered Financial Planner and partner in fee-only planning firm Macdonald Shymko & Co. in Vancouver, to work with the couple. He agrees that they have a problem.

"Almost all their wealth is in real estate and all of this is in one small area of B.C.," the planner says. "There is no diversification. This couple has watched their houses gain 20 per cent in market price just in 2005, capping half a decade of strong growth. But if the market softens and values fall to the levels of just a few years ago, they could see a dramatic decrease in their assets just at the time that they need stability."

Lack of diversification is at the base of another problem -- lack of cash flow. Alf and Doris have $560,000 in mortgages. That costs $5,400 a month or 70 per cent of their after-tax monthly income of $7,666. Their expenses, including mortgage interest and certain property insurance and maintenance costs, exceed rental income by $1,754 a month.

Adjusted for non-cash items such as depreciation, they are actually losing $2,800 a month on their rental properties, Mr. Macdonald calculates. Doris has the income to support their real estate ventures, but once she retires, she and Alf will have to reduce expenses and raise cash flow, the planner explains. Can they generate $65,000 a year from their various assets, they wonder?

If interest rates rise, Alf and Doris will be in a financial bind, the planner adds. The Bank of Canada is widely expected to raise rates as much as one percentage point by the end of 2006, just as Alf's mortgages come up for renewal. The couple's cash flow could fall $13,200 a year if interest rates rose to 8 per cent, Mr. Macdonald warns. Clearly, their retirement income is going to be dependent on how well they cope with rising interest rates, volatile real estate values and vacancy rates, the planner notes.

Not only do the houses strain the couple's current budget, they are also a drag on Alf's time. He spends 30 hours a week tending them. He could hire a property manager, but that would generate extra expenses his cash flow can't sustain.

To escape from the potential vise of rising interest rates and the decline in real estate values that they could trigger, Alf and Doris need to reduce their debts, Mr. Macdonald says. They can do that by selling one of their rental properties this year. With local real estate prices at a record high, they can sell one house with an estimated market price of $525,000. That property would trigger relatively low capital gains tax in comparison with their other properties with larger accrued gains. That sale would reduce their net debt to just $34,000 and reduce their leverage dramatically.

Alf and Doris should sell another property in 2007 in order to avoid two major hits of capital gains in 2006, the planner says. If they lend money to their buyer, financing the sale over a period of five years, they can spread taxable capital gains even further, the planner explains. If they do that, the mortgage payments they receive will add to their retirement income. The sale will have turned negative cash flow into spendable money.

Over the following five to 10 years, Alf and Doris should sell their remaining rental properties, Mr. Macdonald recommends. That will produce ample cash flow and make it easier to get away from the maintenance duties that currently tie Alf down. They will reduce direct exposure to rising interest rates and reduce the money they spend subsidizing their properties.

Doris's $52,000 annual pension, available at age 65, will be the base for the couple's retirement. Before age 65, she will receive a bridge benefit of $520 a month. At age 65, the couple can receive CPP payments that will total an estimated $1,159 a month or an annual total of $13,908 in 2006 dollars, and OAS payments, currently $484.63 a month or $11,631 a year, also in 2006 dollars. Add in the potential cash flow of $100,000 a year as a pretax return from a conservatively estimated $2-million in net value they can realize from the properties over time, and the couple will have annual pretax income of $177,548, far more than their modest retirement objective. RRSP-based income from an annuity or a registered retirement income fund will add to the total. The OAS clawback, which currently begins at about $61,000 a year, will reduce their income somewhat, Mr. Macdonald predicts.

"We have known for 20 years that we have been subsidizing our houses," Alf explains. "We have sacrificed current income for future capital gains. Now that we have the gains, and knowing that our market is in a boom, we are inclined to take Mr. Macdonald's advice and sell some property. We can use that money to take care of Doris's parents, who are in their 80s, and perhaps save some to finance the later years of our own retirement when we might have to increase our spending in order to provide for a decent level of care."